Peculiar Move by Dollar and Small Caps

Peculiar Move by Dollar and Small Caps

November 25, 2016

The two big stories since the Nov. 8 presidential election have been a surge higher for the US dollar, and a big outperformance by small cap stocks. The two can be seen in this week’s chart, although understanding what is happening takes a little bit of explanation.

The upper plot is the US Dollar Index, a combination of multiple currencies exchange rates versus the dollar. It is perhaps not a perfect representation of the overall value of the dollar, but it is the most commonly used one.

The lower plot is a relative strength ratio for the Russell 1000 Index (large cap) versus the Russell 2000 (small cap). It is calculated simply by taking one index’s daily value and dividing it by the other’s. A move higher means that large caps are outperforming on a relative basis. A down move means that small caps are outperforming, which is what they have been doing in a big way lately.

Problem is, this is not the normal condition for these two plots. Normally they have a positive correlation, which makes sense. A higher value for the dollar is more problematic for smaller companies to compete for sales overseas, because they may not have the same ability to hedge currency translations like the big cap firms do. So in theory, a rising dollar should lead to large cap relative outperformance, making the relative strength line rise.

We have seen episodes before when the US Dollar Index rose while this relative strength line was falling, and the basic point is that they do not tend to end well for the dollar trend. Given the way that these two have related to each other in the past, it is not possible for this current condition to last much longer.

Historically, after a divergence like this, it has been possible for small cap outperformance to continue for a while (i.e. lower plot moving even further downward). But these moments tend to be terminal for the dollar move.

But, you ask, what about if the Fed does raise interest rates by a quarter point at the Dec. 13-14 meeting? Wouldn’t that push the dollar higher?

My answer is that the Dollar Index has already risen by 3.65% since election day, so it is not like a quarter point Fed rate hike (or not) is really the driving force. And the Fed Funds futures market appears to have fully discounted a rate hike, so it is not like the actuality is going to have any power when (and if) it does arrive.

The most likely outcome is that currency traders realize how far they have wandered off course, and get to work on the corrective action.

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